How does cost averaging work?
Let’s say you’ve got a large pot of money to play with. You might have received an inheritance, got a big work bonus or even won the lottery. You could choose to invest it all at once, putting that lump sum into stocks and shares. But that might feel a bit risky to some, which is where cost averaging comes in.
With this approach, you drip feed your investment into the market, making regular contributions. Let’s say you have £50,000 to invest. Instead of dropping it all into the market at once, you invest £1,000 a month over 50 months. This spreading it out approach is called cost averaging or pound-cost averaging.
I get it, but why’s it called cost averaging?
It’s not just a name that investment managers have cooked up to make themselves sound clever, there’s some financial science behind it. Every small investment you make of that £50,000 will buy fund units at different prices.
Your first £1,000 may buy them at 56p, say, while a later investment might buy them at 65p or 30p. At the end of your investment, you’ll have paid an average price for your units - hence cost averaging.
What are the positives of drip-feeding my investment?
The main attraction of this approach is if you’re cautious or risk averse. It protects you from the stock you invest in crashing overnight with all of your lump sum in it. Instead, your smaller regular investments lets you keep an eye on how your portfolio is performing and if there are adverse market movements, you’re more insulated against them. Nobody wants to put all their money in at the top of the market.
Also, if the market does experience a downturn, your next investment may well be at a cheaper unit price, so you’ll get more units for your money. Of course, that depends on luck. Another benefit of cost averaging is if you’re quite timid about investing but feel it’s something you should do. It lets you get your money working for you, while shielding most of your lump sum from market volatility.
What are the downsides of the cost averaging approach?
Any wealth management company worth their salt will run through both the ups and downs of different investment approaches. And cost averaging certainly does have potential downsides. Whilst it’s a disciplined way to build up a portfolio over time, that same strategy generally leads to lower returns and slower growth than investing a lump sum.
£50,000 invested in one go in a fund that grows consistently will have markedly better returns than £1,000 a month over 50 months in the same fund. Why? Because most of your smaller investments will be at higher unit prices as the fund rises. Analysis of the global stock market on a month by month basis shows that shares tend to go up rather than down, so drip-feeding your investment is more likely to mean you’re buying as prices go up rather than when they’re on the decline.
Should I try my hand at cost averaging?
Let’s say you want to invest in the UK stock market - you and your financial planner might feel a bit more secure investing a lump sum. It will fluctuate but over the long term you’ll probably see a decent return. Then let’s also say you want to invest in something a little more volatile, with the potential for higher returns but also larger losses. That’s where cost averaging might work for you.
There’s no reason you shouldn’t have a mixture of investment types - we’ve talked about the benefits of diversified portfolios elsewhere - and therefore no reason why you can’t have lump sums in one market while taking a cost averaging approach to another. The drip-feed strategy also works if you want to take a hands-off approach to investing, making regular deposits into your investments without micro-managing them.